Mid-cap investing delivers higher returns (than large-caps) if you can stomach the accompanying higher volatility. Many investors have long grappled with this dilemma. For those who seek better protection during rough patches, using the quality factor in mid-cap selection can be a way out. UTI Mutual Fund has launched UTI Nifty Midcap 150 Quality 50 Index Fund, an open-ended scheme replicating/tracking Nifty Midcap 150 Quality 50 Total Return Index (TRI). The new fund offer for this smart beta index fund closes April 5 and the scheme will re-open for subscription and redemption on ongoing basis from April 15. DSP MF had launched an exchange-traded fund (ETF) based on this index in December 2021.

From good to better

Earlier this month, we had written here about the virtues of Nifty Midcap 150 index over other indices or fund alternatives. The Nifty Midcap 150 Quality 50 index includes top-50 companies from its parent Nifty Midcap 150 index, selected based on their 'quality' scores. The quality score for each company is determined based on return on equity, financial leverage (except for financial services companies) and earning per share (EPS) growth variability of each stock analysed during the previous five financial years. The weight of each stock in the index is based on a combination of the stock's quality score and its free-float market capitalisation. The index is rebalanced semi-annually (June and December).

So, the important question is: how does Nifty Midcap 150 Quality 50 better Nifty Midcap 150? First, historical performance gives quality index the edge. Nifty Midcap 150 Quality has outperformed Nifty Midcap 150 since inception (19.7 per cent vs. 16.5 per cent returns) and 11 times out of last 17 financial years. So, quality selection within mid-caps works better based on evidence presented by back-tested data. Second — and this may be one of the reasons for out-performance — the quality mid-cap index offers better downside protection. Be it global financial crisis, Eurozone debt crisis, volatile period post-LTCG imposition on equities, or the Covid pandemic, Nifty Midcap 150 Quality 50 has fallen 4-14 percentage points lesser than Nifty Midcap 150 index. Third, monthly return distribution data shows Nifty Midcap 150 Quality 50 has captured 89 per cent of Nifty Midcap 150 up moves, whereas it has captured 74 per cent of Nifty Midcap 150 down moves. This is also a signal of downside protection.

The differentiators

Nifty Midcap 150 Quality 50 has higher exposure than the parent index to sectors with higher return on equity and lower earnings variability such as IT, consumer goods, industrial manufacturing etc. Also note, the quality index has no exposure to sectors with higher debt to equity ratio such as cement, construction, power, telecom etc. The top-10 holdings of Nifty Midcap 150 Quality 50 index are Page Industries, Tata Elxsi, Crompton Greaves Consumer Electricals, ICICI Securities, Mindtree, BEL, Voltas, Mphasis, Supreme Industries and Astral. The overlap with top-10 of parent index is limited to Voltas, Mphasis, Crompton, BEL and Mindtree.

In terms of returns, Nifty Midcap 150 Quality 50 TRI has delivered better risk-adjusted returns than the parent index over medium to long-term investment horizon (three, five, seven and 10 years). Standard deviation (SD) of quality variant is broadly 200-300 basis points lower across periods (see table). More aggressive investors may be comfortable with an investment strategy that offers higher-than-average volatility, while more conservative investors may stick to lower SD products.

While the Nifty Midcap 150 Quality 50 index offers good risk-adjusted return potential for long-term investors, one should not ignore the risks. One, the valuation of the basket of stocks that make up the Nifty Midcap 150 Quality 50 - at a Price to Earnings (PE) valuation of 26 times - is at a premium to large-cap index such as Nifty 100. Two, even an investor in a Nifty Midcap 150 Quality 50 index fund has to stomach sizeable short-term losses in order to gain from its long-term performance.

The ‘Quality 50’ Index
Includes top-50 companies from Nifty Midcap 150 index selected based on 'quality' scores
Quality score based on RoE, financial leverage and EPS growth variability over the last five fiscals
Weight of each stock based on the stock's quality score and free-float market capitalisation

At a time when actively-managed mid-cap funds are finding it difficult to generate alpha, investing in mid-cap index-based funds should play out well. UTI Nifty Midcap 150 Quality 50 Index Fund may be an answer for investors looking for a passive fund which brings a disciplined approach to pure-play midcap portfolio construction, while adhering to the defined quality selection process. We will have to wait and see how the newly launched scheme achieves return equivalent to returns of the underlying index while minimising tracking error.

comment COMMENT NOW